7 ways your brain is losing you money

Behavioral finance: 7 ways your brain is losing you money

“Investors are ‘normal,’ not rational,” says Meir Statman, one of the leading thinkers in behavioral finance.

Behavioral finance aims to better understand why people make the financial decisions they do. And it’s a booming field of study. Top behavioral finance gurus include Yale’s Robert Shiller and GMO’s James Montier.

Your brain thinks it’s great at investing

Overconfidence may be the most obvious behavioral finance concept. This is when you place too much confidence in your ability to predict the outcomes of your investment decisions.

Overconfident investors are often underdiversified and thus more susceptible to volatility.

Source: CFA Institute

Your brain doesn’t know how to handle new information.

Daniel Goodman / Business Insider.com

Anchoring is related to overconfidence. For example, you make your initial investment decision based on the information available to you at the time. Later, you get news that materially affects any forecasts you initially made. But rather than conduct new analysis, you just revise your old analysis.

Because you are anchored, your revised analysis won’t fully reflect the new information.

Source: CFA Institute

Your brain is too focused on the past.

A company might announce a string of great quarterly earnings. As a result, you assume the next earnings announcement will probably be great too. This error falls under a broad behavioral finance concept called representativeness: you incorrectly think one thing means something else.

Another example of representativeness is assuming a good company is a good stock.

Source: CFA Institute

Your brain doesn’t like to lose.

Loss aversion, or the reluctance to accept a loss, can be deadly. For example, one of your investments may be down 20% for good reason. The best decision may be to just book the loss and move on. However, you can’t help but think that the stock might comeback.

This latter thinking is dangerous because it often results in you increasing your position in the money losing investment. This behavior is similar to the gambler who makes a series of larger bets in hopes of breaking even.

Source: CFA Institute

Your brain remembers everything.

How you trade in the future is often affected by the outcomes of your previous trades. For example, you may have sold a stock at a 20% gain, only to watch the stock continue to rise after your sale. And you think to yourself, “If only I had waited.” Or perhaps one of your investments fall in value, and you dwell on the time when you could’ve sold it while in the money. These all lead to unpleasant feelings of regret.

Regret minimization occurs when you avoid investing altogether or invests conservatively because you don’t want to feel that regret.

Source: CFA Institute

Your brain likes to go with the trends.

RBC Capital Markets

Your ability to tolerate risk should be determined by your personal financial circumstances, your investment time horizon, and the size of an investment in the context of your portfolio. Frame dependence is a concept that refers to the tendency to change risk tolerance based on the direction of the market. For example, your willingness to tolerate risk may fall when markets are falling. Alternatively, your risk tolerance may rise when markets are rising.